Presentation on theme: "Class 11 Bond Futures and Hedging Interest-Rate Risk"— Presentation transcript:
1Class 11 Bond Futures and Hedging Interest-Rate Risk FIXED INCOME ANALYSISClass 11Bond Futures and HedgingInterest-Rate Risk
2Outline Futures contracts and forward contracts Basic features of various interest-rate futures contractsCheapest-to-deliver issue for a Treasury bond futures contract and how it is determinedTheoretical price of a futures contractHow the theoretical price of a Treasury bond futures contract is affected by the delivery optionsHow futures contracts are used in bond portfolio managementCalculating the hedge ratio and the number of contracts to short when hedging with Treasury bond futures contracts
3Futures ContractsA futures contract is a firm legal agreement between a buyer (seller) and an established exchange or its clearinghouse in which the buyer (seller) agrees to take (make) delivery of something at a specified price at the end of a designated period of time.The price at which the parties agree to transact in the future is called the futures price.The designated date at which the parties must transact is called the settlement date.The contract with the nearest settlement date is called the nearby futures contract.The next futures contract is the one that settles just after the nearby contract.The contract furthest away in time from settlement is called the most distant futures contract.
4Forward ContractsJust like a futures contract, a forward contract is an agreement for the future delivery of the underlying at a specified price at the end of a designated period of time.Futures contracts are traded on organized exchanges and are standardized agreements as to the delivery date (or month) and quality of the deliverable.A forward contract differs in that it has no clearinghouse, they are usually nonstandardized contracts (i.e., the terms of each contract are negotiated individually between buyer and seller), and typically they have nonexistent or extremely thin secondary markets.Because there is no clearinghouse that guarantees the performance of a counterparty in a forward contract, the parties to a forward contract are exposed to counterparty default risk.
5Key Differences Between Futures And Forwards Futures are standardized contracts, which reduce transaction costs.Futures are exchange-traded, which provides liquidity.Futures are marked to market daily, and the exchange clearinghouse warrants performance, which reduces default risk.Forward contracts are customized, which improves hedging efficiency.
6Futures and Forward Contract Payoffs Seller Perspective
7Key Terms for Futures Contracts Futures price: agreed-upon price (similar to strike price in option markets).PositionsLong position - agree to buy.Short position - agree to sell.InterpretationLong : believe price will rise.Short : believe price will fall.Profits on positions at maturity (zero-sum game)Long = spot price ST minus futures price F0.Short = futures price F0 minus spot price ST.
8Mechanics of Futures Trading Opening PositionWhen an investor takes a position in the market by buying a futures contract, the investor is said to be in a long position or to be long futures.If, instead, the investor’s opening position is the sale of a futures contract, the investor is said to be in a short position or short futures.Liquidating a PositionA party to a futures contract has two choices on liquidation of the position.First, the position can be liquidated prior to the settlement date.The alternative is to wait until the settlement date.For some futures contracts, settlement is made in cash only. Such contracts are referred to as cash-settled contracts.
9Mechanics of Futures Trading (cont’d) Role of the ClearinghouseAssociated with every futures exchange is a clearinghouse.A futures contract is an agreement between a party and a clearinghouse associated with an exchange.The clearinghouse makes it simple for parties to a futures contract to unwind their positions prior to the settlement date.When an investor takes a position in the futures market, the clearinghouse takes the opposite position and agrees to satisfy the terms set forth in the contract.Because of the clearinghouse, the investor need not worry about the financial strength and integrity of the party taking the opposite side of the contract.Besides its guarantee function, the clearinghouse makes it simple for parties to a futures contract to unwind their positions prior to the settlement date.
10Mechanics of Futures Trading (cont’d) Margin RequirementsWhen a position is first taken in a futures contract, the investor must deposit a minimum dollar amount per contract as specified by the exchange.This amount, called the initial margin, is required as deposit for the contract.At the end of each trading day, the exchange determines the settlement price for the futures contract.This price is used to mark to market the investor’s position, so that any gain or loss from the position is reflected in the investor’s equity account.
11Mechanics of Futures Trading (cont’d) Margin RequirementsThe maintenance margin is the minimum level (specified by the exchange) by which an investor’s equity position may fall as a result of an unfavorable price movement before the investor is required to deposit additional margin.The additional margin deposited, called the variation margin, is the amount necessary to bring the equity in the account back to its initial margin level.The concept of margin differs for securities and futures.When securities are acquired on margin, the difference between the price of the security and the initial margin is borrowed from the broker with the security purchased serving as collateral for the loan.For futures contracts, the initial margin, in effect, serves as “good faith” money, an indication that the investor will satisfy the obligation of the contract.
12Risk and Return Characteristics of Futures Contracts The buyer of a futures contract will realize a profit if the futures price increases; the seller of a futures contract will realize a profit if the futures price decreases.If the futures price decreases, the buyer of a futures contract realizes a loss while the seller of a futures contract realizes a profit.When a position is taken in a futures contract, the party need not put up the entire amount of the investment. Instead, only initial margin must be put up.Although the degree of leverage available in the futures market varies from contract to contract, the leverage attainable is considerably greater than in the cash market.Futures markets can be used to reduce price risk.Without the leverage possible in futures transactions, the cost of reducing price risk using futures would be too high for many market participants.
13Currently Traded Interest-Rate Futures Contracts Most major financial markets outside the United States have futures contracts similar to the U.S.Several of the more important interest-rate futures contracts in the United States are described in the following slides.For the first three–Treasury bills futures contract, Eurodollar futures contract, and federal funds futures contract–the underlying interest rate is a short-term (money market) interest rate.For the other contracts–Treasury bond futures, Treasury notes futures, and municipal note index futures–the underlying interest rate is a longer term interest rate.Most major financial markets outside the United States have similar futures contracts in which the underlying security is a fixed-income security issued by the central government.
14Markets for Interest-Rates Futures The International Money Market of the Chicago Mercantile Exchange (www.cme.com)The Chicago Board of Trade (www.cbot.com)The Sydney Futures ExchangeThe Toronto Futures ExchangeThe Montréal Stock ExchangeThe London International Financial Futures Exchange (www.liffe.com)The Tokyo International Financial Futures ExchangeLe Marché à Terme International de France (www.matif.fr)Eurex (www.eurexchange.com)
16Currently Traded Interest-Rate Futures Contracts (cont’d) Eurodollar FuturesEurodollar futures contracts are traded on both the International Monetary Market of the Chicago Mercantile Exchange and the London International Financial Futures Exchange.The Eurodollar certificate of deposit (CD) is the underlying for this contract.A Eurodollar CD is a dollar-denominated CD issued outside of the United States, typically by a European bank.Three-month LIBOR is the underlying for the Eurodollar futures contract.That is, the parties are agreeing to buy and sell “three- month LIBOR.”
17Currently Traded Interest-Rate Futures Contracts (cont’d) Eurodollar FuturesA Eurodollar futures contract is quoted on an index price basis.From the futures index price, the annualized futures three-month LIBOR is determined as follows: 100 minus the index price.For example, a Eurodollar futures index price of means the parties to this contract agree to buy or sell the three-month LIBOR for 5.48%.Since the underlying is an interest rate, which obviously cannot be delivered, this contract is a cash- settled contract.
18Currently Traded Interest-Rate Futures Contracts (cont’d) Eurodollar FuturesThe face value for a Eurodollar Futures contract is $1 million.A one-tick change in the index price for this contract is 0.01; that is, an index price change of, for example, to is 0.01 or one tick.An index price change from to changes the three-month LIBOR from 5.48% to 5.47%.In terms of basis points, a one-tick change in the index price means a1-basis-point (0.0001) change in the three-month LIBOR.The simple interest on $1 million for 90 days is equal to$1,000,000 × (LIBOR × 90/360)If LIBOR changes by 1 basis point (0.0001), then$1,000,000 × ( × 90/360) = $25Hence, a one-tick change in the index price or, equivalently, a 1- basis-point change in the three-month LIBOR means a $25 change in the value of the contract.
19Currently Traded Interest-Rate Futures Contracts (cont’d) Eurodollar FuturesThe minimum price fluctuation for the index price is a half a tick, or $12.50.In the nearest trading month for this contract, the minimum index price fluctuation is a quarter tick, or $6.25.The contracts are listed for March, June, September, and December (referred to as the “March cycle”), 40 months in the March quarterly cycle, and the four nearest serial contract months.To understand this, see Exhibit 27-1, which shows the contracts listed on the CME on January 2, 2008.Also shown in the Exhibit 27-1 is the first day of trade, the last day of trade, the cash settlement date, and the date the contract will be deleted.
20Exhibit 27-1 Listed CME Eurodollar Futures Contracts on January 2, 2008 Seq.No.ContractMonthFirstTradeDateLastCashSettlement1Jan 200807/16/0701/14/0801/18/082Feb 200808/13/0702/18/0802/22/083Mar 200803/19/9803/17/0803/20/084Apr 200810/15/0704/14/0804/18/085May 200811/19/0705/19/0805/23/086Jun 200806/18/9806/16/0806/19/08….39Sep 201609/18/0609/19/1609/22/1640Dec 201612/18/0612/19/1612/22/1641Mar 201703/19/0703/13/1703/16/1742Jun 201706/18/0706/19/1706/22/1743Sep 201709/17/0709/18/1709/21/1744Dec 201712/17/0712/18/1712/21/17Source: Chicago Mercantile Exchange.
21Currently Traded Interest-Rate Futures Contracts (cont’d) Eurodollar FuturesThe Eurodollar futures contract is a cash-settled contract.That is, the parties settle in cash based on three-month LIBOR at the settlement date.Suppose that a trade occurs at and on the settlement date the settlement index price isFrom the perspective of the buyer, the index price increased.Hence, the seller must pay the buyer 0.48.Since one tick is $25 and 0.48 is 48 ticks, the buyer receives from the seller 48 × $25 = $1,200.An alternative way of thinking about this is that the buyer contracted to receive a three-month interest rate of (100.00% %) = 5.48%.
22Currently Traded Interest-Rate Futures Contracts (cont’d) Eurodollar FuturesAt the settlement date, the index price isThis means a three-month LIBOR of 5.00% interest rate is available in the market.The compensation of $1,200 of the seller to the buyer is for the lower prevailing three-month LIBOR of 5.00% rather than the contracted amount of 5.48%.To see how this contract is used for hedging, suppose that a market participant is concerned that its borrowing costs six months from now are going to be higher.To protect itself, it takes a short (selling) position in the Eurodollar futures contract such that a rise in short-term interest rates will benefit.
23Currently Traded Interest-Rate Futures Contracts (cont’d) Eurodollar FuturesTo see this, consider our previous illustration in the Eurodollar futures at (5.48% rate).Suppose at the settlement date the three-month LIBOR increases to 6.00% and, therefore, the settlement index price isThis means that the seller sold the contract for and purchased it for 94.00, realizing a gain of 0.52 or 52 ticks.The buyer must pay the seller 52 × $25 = $1,300.The gain from the short futures position is then used to offset the higher borrowing cost resulting from a rise in short-term interest rates.
24Currently Traded Interest-Rate Futures Contracts (cont’d) Euribor FuturesFor euro-denominated loans and derivatives, when a reference rate is used, it is typically the Euro Interbank Offered Rate (Euribor).Euribor is the rate on deposits denominated in euros.The Euribor futures contract, traded on the NYSE Euronext, and the Eurodollar futures contract are the most actively traded futures contracts in the world.The Euribor futures contract is similar to the Eurodollar futures contract.The unit of trading is €1,000,000, and it is a cash-settled contract.The underlying is 30-day Euribor.
25Currently Traded Interest-Rate Futures Contracts (cont’d) Federal Funds Futures ContractDepository institutions are required to maintain reserves at the Federal Reserve.Banks that have excess reserves do not earn interest on those funds.However, they can lend those funds through the Federal Reserve to other banks that need reserves.The funds lent are called federal funds.The interest rate at which banks lend balances at the Federal Reserve to other banks on an overnight basis called the federal funds rate or simply fed funds rate.The 30-day federal funds futures contract, traded on the CBOT, is designed for financial institutions and businesses that want to control their exposure to movements in the federal funds rate.These contracts are marked to market using the effective daily federal funds rate as reported by the Federal Reserve Bank of New York.
26Currently Traded Interest-Rate Futures Contracts (cont’d) Treasury Bond FuturesThe Treasury bond futures contract is traded on the Chicago Board of Trade (CBOT).The underlying instrument for a Treasury bond futures contract is $100,000 par value of a hypothetical 20-year 6% coupon bond.The futures price is quoted in terms of par being 100.Quotes are in 32nds of 1%. Thus, a quote for a Treasury bond futures contract of means 97 and 16/32nds, orSo if a buyer and seller agree on a futures price of 97-16, this means that the buyer agrees to accept delivery of the hypothetical underlying Treasury bond and pay 97.50% of par value, and the seller agrees to accept 97.50% of par value.Because the par value is $100,000, the futures price that the buyer and seller agree to transact for this hypothetical Treasury bond is $97,500.
27Currently Traded Interest-Rate Futures Contracts (cont’d) Treasury Bond FuturesThe minimum price fluctuation for the Treasury bond futures contract is a 32nd of 1%. The dollar value of a 32nd for a $100,000 par value (the par value for the underlying Treasury bond) is $31.25.The seller of a Treasury bond futures who decides to make delivery rather than liquidate his position by buying back the contract prior to the settlement date must deliver some Treasury bond.The CBOT allows the seller to deliver one of several Treasury bonds that the CBOT declares is acceptable for delivery.The specific bonds that the seller may deliver are published by the CBOT prior to the initial trading of a futures contract with a specific settlement date.
28Currently Traded Interest-Rate Futures Contracts (cont’d) Treasury Bond FuturesExhibit 27-2 shows the Treasury issues that the seller can select from to deliver to the buyer of four.Treasury bond futures contract by settlement month.The CBOT makes its determination of the Treasury issues that are acceptable for delivery from all outstanding Treasury issues that meet the following criteria:An issue must have at least 15 years to maturity from the date of delivery if not callable; in the case of callable Treasury bonds, the issue must not be callable for at least 15 years from the first day of the delivery month.
29Exhibit 27-2 Treasury Bonds Acceptable for Delivery and Conversion Factors for Treasury Settlement MonthCouponMaturity DateJune 2008Sep. 2008Dec. 2008Mar. 20094 1/202/15/360.79920.79980.80070.80134 3/402/15/370.83030.83080.83150.8320505/15/370.86370.86420.86460.86525 1/411/15/280.91270.91330.91380.914502/15/290.91225 3/802/15/310.92340.92370.92420.9245….6 5/802/15/271.06931.06861.06821.06766 3/408/15/261.08191.08111.08061.07986 7/808/15/251.09251.09151.09091.08997 1/802/15/23—–7 1/211/15/241.15421.15291.15131.15007 5/802/15/251.16871.16711.16571.1640No. of eligible issues1918
30Currently Traded Interest-Rate Futures Contracts (cont’d) Treasury Bond FuturesIn addition to the eligible issues shown in the Exhibit 27-2, newly issued Treasury bonds would qualify for delivery.To make delivery equitable to both parties, the CBOT has introduced conversion factors for determining the invoice price of each acceptable deliverable Treasury issue against the Treasury bond futures contract.The conversion factor is determined by the CBOT before a contract with a specific settlement date begins trading.Exhibit 27-2 shows for each of the acceptable Treasury issues for each contract the corresponding conversion factor.The conversion factor is constant throughout the trading period of the futures contract for a given settlement month.The short must notify the long of the actual bond that will be delivered one day before the delivery date.
31Conversion FactorWhen the underlying asset of a futures contract is hypothetical, the seller of the contract still has to deliver a real asset (or sometimes cash) to settle the contract.May differ from the hypothetical asset in terms of coupon rate.May differ from the hypothetical asset in terms of maturity.Conversion factor lets you determine how many units of the actual asset are worth as much as one unit of the hypothetical underlying asset.Given a futures contract and an actual asset to deliver, it is a constant factor which is known in advance.Conversion factors for next contracts to mature are available on the web sites of all futures markets.
32Conversion Factor (cont'd) ConsiderA future contract whose hypothetical underlying asset is an m-year maturity bond with a coupon rate equal to r.Suppose that the actual asset delivered by the seller of the futures contract is an x-year maturity bond with a coupon rate equal to c.Expressed as a percentage of the nominal value, the conversion factor, denoted CF, is the present value, at the maturity date of the futures contract, of the actual asset discounted at rate r.ExampleConsider a 1-year futures contract whose underlying asset is a hypothetical 10-year bond with a 6% annual coupon rate.Suppose that the asset to be delivered is at date 1 a 10-year bond with a 5% annual coupon rate. Then
33Conversion Factor (cont'd) The conversion factor isThe seller of the futures contract receives credit for delivering $ per $1000 of contract value when she delivers the bond on the settlement date.
34ExampleThe Bloomberg screen below provides conversion factors for the next CBOT US 10-year note futures contracts maturing on March 2002 (TYH2), June (TYM2), and September 2002 (TYU2).For example, the conversion factor associated with TYH2 for the 6 1/2 fixed-coupon Treasury note maturing on 02/15/2010 is %.
35Currently Traded Interest-Rate Futures Contracts (cont'd) Treasury Bond FuturesThe price that the buyer must pay the seller when a Treasury bond is delivered is called the invoice price, which is given as: invoice price = (contract size × futures contract settlement price × conversion factor) + accrued interestIn selecting the issue to be delivered, the short will select from all the deliverable issues the one that costs the least.This issue is referred to as the cheapest-to-deliver issue; it plays a key role in the pricing of this futures contract.Knowing the price of the Treasury issue, the seller can calculate the return, which is called the implied repo rate.The cheapest-to-deliver issue is then the one issue among all acceptable Treasury issues with the highest implied repo rate because it is the issue that would give the seller of the futures contract the highest return by buying and then delivering the issue.
36Cheapest to DeliverSeller of the contract delivers a bond with price CP and receives the invoice price IP from the buyer.A profit-motivated seller’s objective is to find the bond that achievesMax (IP - CP) = Max (futures price x CF – quoted price)
37Cheapest to Deliver Example Consider a futures contract:Contract Size = $100,000Futures Price= 97Three bonds denoted A,B and C are available:Search for the bond that maximizes the quantity IP - CP.The cheapest to deliver is bond C.Quoted PriceConversion Factor (CF)IP-CPBond A%%$ 3,065Bond B118.90-6,336Bond C131.254,435
38Currently Traded Interest-Rate Futures Contracts (cont'd) Treasury Notes FuturesThere are three Treasury note futures contracts: 10- year, five-year, and two-year.All three contracts are modeled after the Treasury bond futures contract and are traded on the CBOT.The underlying instrument for the 10-year Treasury note futures contract is $100,000 par value of a hypothetical 10-year 6% Treasury note.There are several acceptable Treasury issues that may be delivered by the short.An issue is acceptable if the maturity is not less than 6.5 years and not greater than 10 years from the first day of the delivery month.
39Pricing and Arbitrage in the Interest-Rate Futures Market There are several different ways to price futures contracts with each approach relying on the “law of one price.”The “law of one price” states that a given financial asset (or liability) must have the same price regardless of the means by which it is created.The law of one price implies that the synthetically created cash securities must have the same price as the actual cash securities.Similarly, cash instruments can be combined to create cash flows that are identical to futures contracts.By the law of one price, the futures contract must have the same price as the synthetic futures created from cash instruments.
40Pricing and Arbitrage in the Interest-Rate Futures Market (cont'd) Pricing of Futures ContractsThe theoretical price of a futures contract is equal to the cash or spot price plus the cost of carry.The cost of carry is equal to the cost of financing the position less the cash yield on the underlying security. The shape of the yield curve will affect the cost of carry.There are several reasons why the actual futures price will depart from the theoretical futures price.In the case of the Treasury bond futures contracts, the delivery options granted to the seller reduce the actual futures price below the theoretical futures price suggested by the standard arbitrage model.
41Pricing and Arbitrage in the Interest-Rate Futures Market (cont'd) Theoretical Futures Price Based on Arbitrage ModelThe theoretical futures price may be at a premium to the cash market price (higher than the cash market price) or at a discount from the cash market price (lower than the cash market price), depending on (r – c).The term r – c is called the net financing cost because it adjusts the financing rate (r) for the coupon interest rate earned (c).The net financing cost is more commonly called the cost of carry, or simply carry.Positive carry means that the current yield earned is greater than the financing cost.Negative carry means that the financing cost exceeds the current yield.
42Forward Contract Pricing Consider at date t an investor who wants to hold at a future date T one unit of a bond with coupon rate c and time t price Pt .Suppose investors can lend and borrow funds at the same rate (r).She faces the following alternatives:Either buy at date t a forward contract from a seller who will deliver at date T one unit of this bond at a fixed price Ft orBorrow money at a rate r to buy this bond at date t.
43Forward Contract Pricing (cont'd) Given that both trades have a cost equal to zero at date t, in the absence of arbitrage opportunities, the cash flows generated by the two operations at date T must be equal.From this equality, we obtainorwith R = 365r/360 and C = 100c/Pt
44Forward Pricing Example On 05/01/01, a forward contract maturing in 6 months (184 days) has as the underlying a bond whose coupon rate and price are 10% and $115, respectively.Assuming a 7% borrowing rate (actual/360), the forward price F05/01/01 is equal to:
45Pricing and Arbitrage in the Interest-Rate Futures Market (cont'd) Closer Look at the Theoretical Futures PriceTypically, the borrowing rate (rB) is greater than the lending rate (rL).The formula that can be used to obtain the upper boundary for the futures price is F(upper boundary) = P[1 + t(rB – c)]where P = cash market price, t = time, in years, to the futures delivery date, rB = borrowing rate, and c = current yield (coupon rate divided by the cash market price).The formula that can be used to obtain the lower boundary for the futures price isF(lower boundary) = P[1 + t(rL – c)]where rL = lending rate.Delivery options should result in a theoretical futures price given by:F = P[1 + t(r – c)] – delivery optionswhere r is the financing rate and the delivery options are the quality option, the timing option, and the wild card option (described in the textbook).
46HedgingHedging with futures calls for taking a futures position as a temporary substitute for transactions to be made in the cash market at a later date.When the net profit or loss from the positions is exactly as anticipated, the hedge is referred to as a perfect hedge.The difference between the cash price and the futures price is the basis.The risk that the basis will change in an unpredictable way is called basis risk.In bond portfolio management, typically, the bond to be hedged is not identical to the bond underlying the futures contract.This type of hedging is referred to as cross hedging.There may be substantial basis risk in cross hedging.
47Hedging (cont’d)A short (or sell) hedge is used to protect against a decline in the cash price of a bond.A long (or buy) hedge is undertaken to protect against an increase in the cash price of a bond.The hedge ratio is chosen with the intention of matching the volatility (i.e., the dollar change) of the futures contract to the volatility of the asset.Assuming a fixed yield spread between the bond to be hedged and the cheapest-to-deliver issue, the hedge ratio is: where PVBP or price value of a basis point refers to the change in price for a one-basis-point change in yield.
48Hedging (cont’d)Given the hedge ratio, the number of contracts that must be sold short is:The formula for the hedge ratio to incorporate the impact of the yield beta is:where the yield beta is derived from the yield of the bond to be hedged regressed on the yield of the cheapest-to- deliver issue.
49Hedging Example (Chapter 27, Problem 19) Suppose that the hedge ratio is 1.30 without any adjustment for the relationship between the yield on a bond to be hedged and the yield on the hedging instrument.Answer the following questions.Suppose that a yield beta of 0.8 is computed. What would the revised hedge ratio be?The revised hedge ratio would be the hedge ratio times the adjustment factor. For the hedge ratio, we have:hedge ratio = volatility of bond to be hedged = 1.3.volatility of hedging instrument
50Hedging Example (cont’d) For the adjustment factor, two approaches have been suggested for estimating the adjustment factor that takes into account the relationship between yield levels and yield spreads: (1) regression approach, and (2) pure volatility approach. The regression approach gives the yield beta. For our problem, the yield beta is 0.8. Thus, for the revised hedge ratio, we have:revised hedge ratio = hedge ratio × adjustment factor= 1.3 × 0.8= 1.04.
51Hedging Example (cont’d) Suppose that the standard deviation for the bond to be hedged and the hedging instrument are 0.09 and 0.10, respectively. What is the pure volatility adjustment, and what would be the revised hedge ratio?For the adjustment factor, two approaches have been suggested for estimating the adjustment factor that takes into account the relationship between yield levels and yield spreads: (1) regression approach, and (2) pure volatility approach. The pure volatility approach gives the yield pure volatility adjustment. For our problem, the pure volatility adjustment is given by:pure volatility adjustment =std. dev. of yield change for bond to be hedged = = 0.9.std. dev. of yield change for CTD issueThus, for the revised hedge ratio, we have:revised hedge ratio = hedge ratio × adjustment factor= 1.3 × 0.9= 1.17.
52ConclusionsA forward contract is an agreement calling for the future delivery of a specified asset at a stated price on an agreed-upon date.A futures contract is similar to a forward contract except that futures contracts have standardized features whereas forwards are customized.Forwards and futures contracts are very useful for hedging purposes, and they are often cheaper and easier to use than bonds.The price of a bond forward or bond futures contract increases (decreases) as interest rates decrease (increase), just like the price of the underlying bond.
53Conclusions (cont'd)Use the cheapest-to-deliver bond for the relevant futures contract in designing hedges and in performing hedging calculations.CF, the conversion factor for the cheapest-to-deliver bond, for each futures contract appears in the hedging formulas to convert the number of hypothetical bonds into the number of cheapest-to-deliver bonds when implementing the hedge.